Tax-Free Bonds Offer Tempting Yields

Portfolio manager Duane McAllister shined during the financial crisis by limiting his exposure to general obligation bonds, which are backed by the tax revenue of states and other issuers. As income and sales taxes dropped during the recession, GOs in Illinois and other states slumped.

McAllister has emphasized revenue bonds, which are backed by income from a single source, such as a sewer system or power producer. By sticking with reliable revenue sources, he outdid most peers in the turmoil of 2008 and 2009.

These days, BMO is beginning to shift back to GOs because income and property taxes are increasing as the economy recovers. "Half the states now have overall revenue that are above where they were before the recession," McAllister says.

Investors seeking a relatively high yield should consider USAA Tax Exempt Intermediate-Term (USATX) , which yields 3.7%. During the past five years, the fund returned 5.6% annually, outdoing 83% of peers. Portfolio manager Regina Shafer boosts yields by holding a sizable stake in bonds rated BBB, the lowest investment-grade rating. "The lower-quality bonds have performed well as the economy has recovered," says Shafer.

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She argues that the BBB bonds remain attractive because they yield considerably more than top-quality issues. A 15-year BBB bond yields 3.5%, compared to a yield of 2.1% for bonds that carry the top rating of AAA.

Another strong performer is Lord Abbett Intermediate Tax Free (LISAX), which returned 6.0% annually during the past five years and outdid 91% of peers. Portfolio manager Dan Solender is keen on hospital issuers that have strong positions in their markets. "A lot of hospitals should thrive as the health sector evolves," he says.

Solender has bought some lower-quality issues. A favorite bond is a 15-year issue from Southwest Airlines (LUV), which is rated BBB- and yields 3.9%.

At the time of publication the author held no positions in any of the stocks mentioned.

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This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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